Executive renumeration - does sunlight disinfect or fertilise?

An abridged version of this article first appeared in the NZ Herald on Friday 2 September 2011.

It is an article of faith lying at the core of corporate and securities law that, as the American jurist Louis Brandeis famously observed, “sunlight is the best disinfectant”. Securities offering documents must disclose all material matters, financial advisers must disclose commissions - and companies must disclose senior executive’s remuneration.

But is our faith misplaced? In the case of executive remuneration disclosure, perhaps.

The boss has always earned a multiple of what the average worker earns. But over the last fifteen years, that multiple has increased. A recent survey estimates that NZX-listed companies now pay their CEO’s an average 18 times what they pay the average worker. If this seems a lot, it pales into insignificance compared to other countries. In the Financial Times (“It’s time to name and shame the corporate scroungers”, 1 August) Neil Stephens points out that the multiplier for FTSE 100 companies has risen from 47 in 1998 to 120 in 2010.

Stephens is concerned at the potentially corrosive effects of a widespread perception that the only “winners” are a privileged few at the top. He is not alone in this. Concerns about what Robert Frank and Philip Cook have dubbed a “winner take all” society are heard across the political spectrum.

Neither is Stephens alone in suggesting that part of the answer is more and better disclosure - witness Brian Gaynor’s reported comments last weekend on New Zealand’s failure to require a sufficient breakdown of CEO remuneration.

But are such calls right? Will “greater transparency” bring allegedly avaricious captains of industry to heel? Or might it, in fact, have the opposite effect?

Numerous jurisdictions (including New Zealand) require senior executive remuneration to be disclosed, at least by public listed companies. So everyone knows what everyone else is paid. This might ratchet up executive remuneration in a number of ways.

First, few chief executives will wish to be paid less than other comparable chief executives. And many companies will share that reluctance – their boards understandably fearful that they will be unable to attract the calibre of individual they require, or that the company itself will be perceived to be below average.

But if both sides of the negotiation are pre-disposed to pay at least the average – and preferably more than average – then the upward march of remuneration is guaranteed: each time remuneration is re-set, the (previous) average becomes the floor, making the (new) average higher, thereby raising the floor for the next re-set, and so on, leading to what economists Michael Faulkender and Jun Yang, in a study of Canadian executive remuneration, called the “Lake Wobegon effect” (after Garrison Keillor’s mythical home town of Lake Wobegon, where all the children are above average).

Secondly, and more speculatively, increased availability of information on income and wealth leads to increased publicity on income and wealth. (How many people have never shown any interest in the Rich List?) Might this, in turn, increase the relative importance to executives of income and wealth as markers of success, and the relative acceptance by boards of increased senior executive remuneration?

Thirdly, and more speculatively still, might greater publicity on executive remuneration generally, and a company’s executive remuneration in particular, make the board unconsciously less reticent about approving even higher incomes in future, because the disclosure requirement in some way gives them greater “licence” to do so?

Before you consign this idea to the “clearly mad” bin, consider some recent evidence on disclosures of interest.

You’d think that telling someone you have a conflict will make it more likely that you will assiduously guard their interests. But it seems this does not necessarily follow.

In an article earlier this year in the Boston Globe (“Deeply Conflicted”, 1 May) Courtney Humphries points to increasing evidence that disclosure of interests can increase the bias shown by the persons making disclosure: a fiduciary disclosing a conflict may be less likely to act in the interests of the beneficiary to whom the disclosure has been made.

It appears that some sort of “moral licensing” phenomenon can arise - the discloser unconsciously treating the disclosure as having partially discharged their obligations to the beneficiary, thereby making them less assiduous in protecting the beneficiary’s interests.

Might a similar psychological phenomenon apply to executive remuneration – the board feeling less reticent about executive remuneration precisely because it is, or will be, disclosed?

Of course, even in the absence of compulsory remuneration disclosure the relevant information would be available via word of mouth and executive remuneration consultants. But there is an important difference between information obtained and provided in private and information obtained and provided publicly – the difference being, precisely, that in the latter case the information is public, and known to be public.

Would it really be that surprising to learn that an executive’s (and a company’s) desire to avoid below-average remuneration is significantly greater when everyone is watching?

Clearly this is speculative. It simply may not be possible to disentangle the effects of compulsory remuneration disclosure from those of other powerful forces leading to “winner take all” markets for talent. And even if compulsory disclosure is shown to increase executive remuneration, this is a genie which may long since have smashed the bottle from which it escaped.

But if there are any graduate students out there with an interest in the law of unintended consequences, I’ve got a suggestion for a research project…

Geof Shirtcliffe is a partner in Chapman Tripp. The ideas expressed here are his own and are not necessarily shared by the firm or its clients.